Why complicate Investments?

Source: Tavaga Research

Date – 30 April 2020

Investing can be a simple exercise, yet simplicity often eludes us. Such is the noise in the financial markets, created by product-peddlers, that we are often befuddled about the nature of investing. 

It may even give us an adrenaline rush to see the markets move up and down, make active investment decisions or buy hot funds or stocks. 

But studies have been showing that a set of well-diversified exchange-traded funds (ETFs) or index funds, firmly entrenched in the passive investment space, can outperform the broad market indices by a sizable margin.

The din around what makes for a savvy investment often leads us to believe that a complex route is often better for investment. Of course, the view is backed by financial institutions that profit even as we transact.

When we benchmark a majority of retail investor portfolios against the broad market indices such as the Nifty50 or the Sensex over time, we find the portfolios lacking the performance of the indices — a cost we, investors, pay for complicating our investments.

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The forces which prevent simplicity 

The belief of us knowing the future

Most of us think that we know or will get to know what will happen in the markets in the future. We constantly try to predict events which are often random. 

What we cannot predict, we expect some expert to tell us about and end up taking random bets on stocks and investment funds that we regret later. 

The way we see profit and loss

There is also the matter of how we view profit and loss. In 1979, psychologists Daniel Kahneman and Amos Tversky published a paper titled, “Prospect Theory: An Analysis Of Decision Under Risk” where they revealed that we, humans, tend to make decisions based on our perceived loss or gain from an event, rather than the actual outcome. The prospect of a loss weighs down on us far more than the prospect of a gain, even if they share the same probability in an event or investment route.

Rational and irrational investor
Source: Tavaga

What it does is make us less willing to take risks with our profits than with our losses. So, we would be more likely to sell a stock when we are making a profit, avoiding the risk of a possible decline in prices but also forgoing the prospect of further increase in prices. 

But if we see prices decline on a stock, then we tend to hold on to it, taking on the risk of a further decline but hoping for an eventual increase in price. 

Researchers of the prospect theory often cite examples like this:-

Say, we have Rs 1,000. We are told of two choices. One, where we have a 50 percent chance of gaining Rs 1,000 more or gaining nothing and two, where we are assured of gaining Rs 500 more. 

Even though the first choice promises a bigger gain than the second choice, most of us would choose the latter because of the certainty of gain, albeit lower.

On the contrary, if we are given another two choices — one, where we have a 50 percent chance of both losing our Rs 1,000 and of losing nothing, and two, a certain loss of Rs 500 — we would most likely opt for the first option. 

We become risk-averse when it comes to gaining and even settle for meager profit, but take on greater risk in trying to limit our losses rather than take a lesser loss on the chin. 

The financial marketplace 

The financial product marketers keep coming up with complex products peppered with jargon like smart beta, derivative instruments etc. that sound intimidating and prevent further questions. Simple products such as those in passive investing strip away excess service charges which complex-sounding financial products inevitably entail.

Stable passive ETF/Index portfolios go a long way

Passive investing involves a simple investment strategy that takes little time, effort and investment knowledge to outperform the markets. 

The crux of such an investing route is to follow a benchmark market index and replicate its performance. It banks on the larger wisdom that governs macroeconomics and eventually, regulates markets. Hence, chances of unique disasters get reduced. With passive investments, an investor can just invest and forget. 

Key products in passive investing include ETFs and index funds.

A Tavaga investor’s portfolio is made up of six well-diversified ETFs. We compared the five-year performance of the portfolios of Tavaga’s user profiles with that of Nifty. The chart below shows actual returns on those portfolios and proves that pays to be a stable investor.

The portfolios’ performances in the Covid-19 crisis have been highlighted in green — they hold their ground despite the broader market crashes

tavaga portfolio returns
Source: Tavaga Research

We further looked up the portfolio returns of our users across different investment periods, and it only reinforced the benefits of passive investing.

The importance of asset allocation in a portfolio

Our portfolio is as good as our asset allocation. Asset allocation is the process of dividing our investment money between asset classes to minimise the risk and maximize the return on the portfolio. 

It works on the principle of negative correlations. For example, if our portfolio consists of two investment products, and one of whose value goes up when the other’s value suffers, then it is beneficial. Because the returns on such a portfolio will be the weighted average returns on both the assets, while the risk in the portfolio will be less than the weighted average risk on both the assets. This would mean we would get higher returns with lower risk.

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